Substitution Effect

The substitution effect describes the change in demand for goods resulting from a shift in their relative prices, without considering income effects. For two goods, X₁ and X₂, a change in the price of X₁ alters their relative price ratio, calculated as P_X2 / P_X1. Graphically, a change in the price of one good affects the slope of the consumer's budget line. The diagram below illustrates the case of a price reduction, ΔP_X1.

When P_X2 changes, the relative price ratio P_X2 / P_X1 is adjusted, causing the slope of the budget line to shift. Assuming no other factors change, the consumer's optimal choice moves from the initial equilibrium point A to a new equilibrium point B. Both points lie on the same indifference curve, meaning the consumer's overall satisfaction or utility remains constant. From a demand perspective, the substitution effect is represented by the segment ES on the X₁ axis and the segment es (in lowercase) on the X₂ axis.

The substitution effect is always negative because the quantity demanded of a good moves inversely to changes in its price. This principle also explains why indifference curves have a downward slope.

Income Effect. The substitution effect is only one of the two effects that occur following a price change. Price fluctuations also impact a consumer's real income (purchasing power) in addition to relative prices. A price decrease increases the consumer’s purchasing power, leading to greater demand for both goods. Conversely, a price increase reduces real income, resulting in lower demand for both goods. In the earlier graph, the income effect combines with the substitution effect, shifting the final equilibrium point from B to C.